Underwhelming Start to iTunes Radio Lights Fire Under Apple

The failure of iTunes Radio to halt the decline of music downloads has prompted Apple Inc. to consider the most dramatic overhaul of its iTunes music store in more than a decade, according to executives familiar with Apple’s internal deliberations.

iTunes Radio, which launched in September with much fanfare, so far only sees about 1%-2% of listeners clicking the buy button, while overall music downloads have been declining upwards of 15%, according to several label executives.

At the same time, Apple is finding that its influence over labels is slipping as YouTube, Spotify, Pandora and other streaming services gather momentum. One independent label said that iTunes’s share of the label’s revenue has eroded from more than 70% in 2012 to about 50% today.

As a result, Apple is being forced to consider options that would have been out of the question a few years earlier – an on-demand streaming service, an iTunes store for Google’s Android devices and negotiating download sales windows that favor Apple as first reported by Billboard.

How Apple transforms iTunes, however, remains hotly debated, both within the company and among Apple’s content partners, sources say. Apple’s desire for a smooth transition is complicated by an urgency that iTunes must move quickly as people move away from downloads, where Apple controls 90% of download music sales in the U.S., towards streaming, where Apple is overshadowed.

Apple declined to comment.

Apple’s problem is two-fold – a shift in consumer behavior toward streaming and the rise in Google’s Android operating system, which runs 38% of all devices shipped worldwide in 2013, compared to 10.4% for iOS, according to Gartner Inc.

In September 2011, Apple took a tentative step towards streaming, launching its Match service, which charges $25 a year to store music from CDs and music bought from iTunes in the cloud, but so far only has about 1 million subscribers, according to label sources. Last September, Apple took a bigger step into streaming with iTunes Radio. The idea was to execute a smooth transition to streaming, while preserving sales via referrals to its download store. While it’s estimated to have become the third-largest pure music streaming service after Pandora and iHeartRadio, according to Edison Research, iTunes Radio has yet to live up to its promise of shoring up sales, said sources familiar with the conversion rates. Even the leading U.S. streaming radio Pandora with over 70 million users each month only generates just $3 million in download sales a month according to executives familiar with the data.

“iTunes Radio hasn’t solved the problem of refreshing the iTunes store,” said a senior label executive. “While listeners are clicking the buy buttons, the traffic it is driving is in the low single digits of listeners.”

iTunes Radio’s “lack of success,” another executive said, “is driving the types of conversations they are having. They know iTunes has to change radically, but they still don’t know which way it will go. But it will be completely different in three to five years. They are committed to making that happen.”

While iTunes Radio has been a disappointment so far in the U.S., label executives say it could still play an important role in other countries around the world like Russia and Brazil, where passive streaming services still haven’t taken hold like Pandora has in the U.S.

Meanwhile, in the U.S., Apple is losing its most valuable customers. “Two-thirds of its high-value customers are now in subscription services,” said one source. “That has been an eye-opener for them.”

Apple’s second big threat is Google. Through Android, Google has excelled where it matters most – mobile. Sales of smartphones equipped with Android accounted for 69.5% across 12 key countries in the fourth quarter of 2013, compared to 23.7% for Apple’s iOS, according to Kantar World panel. More worrisome for Apple is that its share declined while Android gained across all those markets, including the U.S., China, Latin America and Europe.

This places Apple in a familiar conundrum – open up its iTunes store to rival Android devices or risk being losing out on more than half of the mobile market. Apple faced a similar juncture in 2003, when Steve Jobs agonized over whether to make iTunes compatible with Windows PCs. When he finally relented, Jobs announced iTunes for Windows by saying, “Hell froze over.” The decision facing iTunes today regarding Android weighs no less heavily on Jobs’ corporate heirs.

The questions of whether to introduce iTunes for Android and launch an on-demand music service are part of a bigger imperative at Apple as it considers how to position iTunes to capture more of the fast-growing digital entertainment market that it used to own outright. Though iTunes sales grew 25% its 2013 fiscal year to $16.1 billion, making up 9.4% of Apple’s overall revenue, iTunes’ music sales has declined both as a proportion of overall iTunes revenue and in absolute dollars as consumers spend their money elsewhere, according to estimates from Asymco.

“The a-la-carte consumption model is 11 years old and at this point the decline in the U.S. download sales seems unstoppable; it doesn’t seem like the store is refreshable,” says one label executive, who went on to suggest Apple has no choice but to embrace the subscription model.” But that executives believes that while digital sales will continue to deteriorate over the next 9 months, he says that some consumers will still prefer to stick with the download model, leaving Apple to service three channels–the download store, iTunes Radio and a premium subscription model–to reach music fans.

But how Apple approaches the later avenue is critical. It can’t afford another botched launch. With music as the canary in the coalmine, Apple knows it must weigh its strategy carefully.

“When sales are going up, it’s all offensive moves,” said one executive. “Now that sales are going down, they have to make defensive moves. But whatever they decide to do, I wouldn’t bet against them still being No. 1 with the customer. I would bet they will always be.”